So-called “inverse funds” are widely misunderstood and can be tricky to use, but these specialized investments have a place in most portfolios.

In fact, with U.S. stocks having zoomed more than 80% off their March 2009 market lows, now could be the ideal time to add inverse exchange-traded funds to your portfolio.

But there’s definitely a right way and a wrong way to use them.

So it’s worth taking a closer look.

The Lowdown on Inverse ETFs
If you’re not familiar with inverse exchange-traded funds (ETFs) – or haven’t used them, yet – don’t worry. You’re not alone. Despite the fact that they’ve been around a few years, I’ve found that many investors either aren’t aware of them, or don’t quite understand how they can be used.

Others who are familiar with inverse ETFs view them solely as a hedging instrument – and don’t realize that their strategic use can lead to higher, more-consistent returns over time.

That’s ironic, because they’ve proven their worth, time and again – such as during the run-up in oil prices that we saw in 2005 and 2006, and during the financial crisis that got its start in late 2007.

As their name implies, an inverse ETF is a specialized investment vehicle that moves opposite whatever security or index they’re designed to track.

Inverse ETFs trade just like stocks on regular exchanges, which means that investors who want to use them don’t have to have special accounts or approval from their brokers. And because they are priced in “real time” – just like regular stocks (and as opposed to conventional mutual funds) – investors who want to really fine tune their approach can literally monitor their exposure down to the minute or the tick if they wish.

Inverse funds can utilize a variety or combination of financial instruments – including options and futures – to achieve their objectives. And yet, their operation is almost completely invisible to the investor. That makes ETFs ideal for counter-balancing long positions in a diversified portfolio without having to worry about the intricacies of short selling, put options, liquidity, taxes or margin management.

Inverse funds also remove the element of market timing from the equation. And that’s a very good thing, since the vast majority of investors – individual and professional alike – fail to keep pace with the market averages. In fact, in any given year, about three-quarters of all professional managers lag the performance of the Standard & Poor’s 500 Index.

Rydex/SGI created one of the first inverse funds: The Rydex Inverse S&P 500 Strategy Inverse Fund (RYURX). In professional trading circles, it was known as the Rydex URSA, or simply “ursa,” which is Latin for “bear.”

Today, as part of a $1 trillion industry segment, there are more than 100 inverse funds tracking the S&P 500, the Nasdaq Composite Index, the Dow Jones Industrial Average, as well as all sorts of other indices ranging from domestic small caps to foreign choices like the iShares FTSE/Xinhua China 25 Index (NYSE: FXI).

There are even so-called “ultra” inverse funds, which offer double or even triple the inverse results if you want to be more aggressive. These come with their own unique wrinkles because they use leverage to achieve their objectives. But don’t necessarily believe all the bad press they’ve received in recent years. If used properly, they’re hardly the “return killers” pundits would have you believe.

I like to use inverse funds in two ways:

* As an “income stabilizer.”
* And as an “absolute-return producer.”

Let’s take a look at both.

Inverse Funds as an Income Stabilizer …
If you’ve ever been sailing and hit rough water, you might be familiar with something called a “storm anchor.” It’s something that’s thrown overboard in an effort to stabilize the boat.

That’s a great analogy. Because inverse funds are truly non-correlated assets, they serve the same purpose as a storm anchor. So if you’re dependent on income, using inverse funds can stabilize the principal value of your holdings, while allowing you to concentrate on preserving your income.

This is more of a “set-it-and-forget-it” approach to income investing. And research studies underscore that having 5% to 10% of your overall assets in such holdings is just about right.

… And as an Absolute-Return Producer
If you’re more aggressive, you can use inverse funds to achieve absolute returns (a.k.a. profits) during rough market stretches in which everyone else around you is fretting about the losses they’re incurring.

Investors who travel this route typically allocate more than 5% to 10% of their portfolios in inverse-type investments – depending upon what it is that they’re trying to hedge.

Investors in this group also tend to rebalance their inverse funds regularly – sometimes even daily – to accommodate the market’s inevitable ebbs and flows (See related graphic).

Consider, for example, a $10,000 investment that outperforms the markets by 5%. An investor who uses inverse funds to hedge that investment would now want to add an additional $500 to an appropriate inverse fund to rebalance the incremental return (or “alpha,” as it’s referred to by professional investors).

Similarly, if a hedged investment has fallen by 5%, that same investor would want to sell $500 worth of inverse funds to reduce the net exposure to zero ($0.00).

A Worthwhile Sacrifice
In investing, as in physics, there is no “free lunch.” In other words, in order to get the security that these inverse funds provide, you have to give up something.

Because inverse funds move in the opposite direction to the underlying indices they track, they’ll take a little off the top when markets are rising.

However, in a world characterized by out-of-control government spending and markets that are exposed to the risks created by seriously out-of-control financial institutions, that’s an acceptable trade-off. Especially when it comes to the peace of mind I get by using them.

Actions to Take: Although they are specialized investments, I believe “inverse funds” have a place in most portfolios.

Here are a few of my favorite choices to help you get started.

If you’re partial to U.S. stocks, consider the afore-mentioned Rydex Inverse S&P 500 Strategy Inverse Fund (RYURX). It moves opposite the S&P 500 Index.

If you’ve got heavy U.S. Treasury exposure – particularly at the longer end of the spectrum as many investors do right now – consider the Rydex Inverse Government Long Bond Strategy Inverse Fund (RYJUX) or even the iPath U.S. Treasury Long Bond Bear ETN (DLBS). Although the latter is technically an exchange-traded note (ETN), the purpose and function is similar.

If you’re an investor who favors high tech, or who is big into energy, there’s the ProShares Short QQQ ETF (NYSE: PSQ) or the United States Short Oil Fund (NYSE: DNO).

If you find that you share one of my major worries, and are concerned about the outlook for the U.S. dollar, or if you have the majority of your portfolio in dollar-denominated investments, you might find that the PowerShares DB U.S. Dollar Index Bearish (NYSE: UDN) will provide the security that eases those fears.

Finally, if you share my view that China represents the greatest long-term investment potential on the planet – but you still wish to “smooth out” some of the interim volatility that’s certain to come – consider the Ultrashort FTSE/Xinhua China Proshares ETF (NYSE: FXP). This is kind of the yin to the yang of the afore-mentioned iShares FTSE/Xinhua China 25 Index ETF (NYSE: FXI).

– Keith Fitz-Gerald

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Source: Money Morning